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Investing: Why care about stock buybacks?

Why care about buybacks? When a company buys back stock, there are fewer shares available for investors to buy. All other things being equal, those remaining shares should be worth more. What could go wrong?

You have to look at data in context for it to give you useful information. Knowing that someone likes white gym socks, for example, doesn't tell you much unless he adds, "with just a squeeze of lemon."

Knowing that a company plans to buy its own stock back isn't very useful, either, unless you know more information about those plans. All too often, announcements about stock repurchases are just a cynical ploy to boost the stock price. But when a company actually buys back significant amounts of its stock, that can be pretty useful information.

Why care about buybacks? When a company buys back stock, there are fewer shares available for investors to buy. All other things being equal, those remaining shares should be worth more. What could go wrong?

Plenty. First of all, not every company that announces a buyback actually buys back stock. In this case, the only real information you can glean is either that the company is remarkably absent-minded, or that its official announcements aren't to be trusted.

But there are other reasons to be suspicious of stock buybacks:

• Options. Some companies buy back stock simply because they have made options grants to executives and need stock on hand when those execs decide to exercise them. A stock option is the right, but not the requirement, to buy stock at a certain price from the company.

Options can be swell for executives. If you have options to buy 1,000 shares of stock at $20 a share, it's a great deal if the stock is selling at $30. You can exercise the options at $20 and sell the shares for $30.

Just how useful the associated buybacks are for shareholders, however, is another story, because the shares simply go back into circulation when the executives sell them.

• Timing. You would think that a corporation would know when its stock was a real value, and therefore worth buying. You'd be wrong. For example, General Electric bought 160.4 million shares of its own stock in the third quarter of 2007 at an average price of $39.40 a share, according to InsiderScore. GE closed Thursday at $22.28 a share.

• Judgment. One way to judge a company's management is by how it spends its capital. How would you judge this company?

CEO: Hey, we've got $500 million in the bank. What should we do with it?

CFO: Give employees raises? Build a factory? Open some new stores? Develop a new product?

CEO: Nah.

CFO: OK, let's buy back some stock.

So the problem with watching share repurchases is that it's hard to decide whether it's smart buying. But it might be best to simply look at whether a company has fewer shares outstanding now than it did a year ago.

Tim Alward, CEO of Ford Equity Research in San Diego, did just that in 1995 and discovered that companies that actually reduced the number of their shares outstanding tended to outperform those that didn't.

"Even if the reduction was 1%, you got excess return," says Alward, who tested the theory all the way back to the 1970s. "When the reduction was bigger than that — 5% or more — it got real good," he says.

An exchange traded fund based on Alward's research seems to prove him correct. The PowerShares Buyback Achievers Fund (PKW) invests in companies that have reduced their shares outstanding by 5% or more in the past 12 months. The fund has gained an average 8.16% a year the past five years, according to Morningstar.

In contrast, consider the PowerShares Dividend Achievers fund (PFM), which invests in stocks that have consistently raised their dividend each year for a decade. The fund has gained 4.02% a year the past five years.

Some of the Dividend Achievers' underperformance can be explained by the collapse of bank stocks during the 2007-2009 bear market. Bank stocks, once reliable dividend hikers, became dividend pikers during the credit crisis. But not all. The Buyback Achievers have beaten the Dividend Achievers even in the past three years. The buyback fund has gained 17.11% a year the past three years, vs. 14.53% for the dividend fund.

PowerShares Buyback Achievers isn't a cheap fund, by ETF standards: Its expense ratio is 0.71%, and you'll have to pay a commission to buy the fund. And, as the Securities and Exchange Commission is fond of reminding us, past performance is no guarantee of future returns.

Nevertheless, a shrinking share base can be a meaningful bit of data, in part because it strips away companies that announce but don't actually repurchase. Otherwise, it might be just as easy to buy the fund.